What is Subordination About? Credit Risk and Subordination Levels in Commercial Mortgage-Backed Securities (CMBS)

40 Pages Posted: 19 Nov 2010 Last revised: 21 Jul 2015

See all articles by Xudong An

Xudong An

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Yongheng Deng

Wisconsin School of Business, University of Wisconsin-Madison

Joseph Nichols

Board of Governors of the Federal Reserve System

Anthony B. Sanders

George Mason University - School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: June 2014

Abstract

Subordination is designed to provide credit risk protection for senior commercial mortgage-backed securities (CMBS) tranches by allocating the initial credit losses to the more junior tranches. Subordination level should in theory reflect the underlying credit risk of the CMBS pool. In this paper, we test the hypothesis that subordination is purely about credit risk as intended. We find a very weak relation between subordination levels and both the ex post and ex ante measures of credit risk, rejecting our null-hypothesis. Alternatively, we find that subordination levels were driven by non-credit risk factors, including supply and demand factors, deal complexity, issuer incentive and a general time trend. We conclude that, contrary to the traditional view, subordination level is not just a function of credit risk. Instead, it also reflects the market need of a certain deal structure and is influenced by the balance of power among issuers, credit rating agencies (CRAs) and investors.

Suggested Citation

An, Xudong and Deng, Yongheng and Nichols, Joseph and Sanders, Anthony Bown, What is Subordination About? Credit Risk and Subordination Levels in Commercial Mortgage-Backed Securities (CMBS) (June 2014). Journal of Real Estate Finance and Economics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1710785 or http://dx.doi.org/10.2139/ssrn.1710785

Xudong An (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Yongheng Deng

Wisconsin School of Business, University of Wisconsin-Madison ( email )

4110 Grainger Hall
975 University Avenue
Madison, WI 53706
United States
+1 (608) 262-4865 (Phone)

HOME PAGE: http://https://bus.wisc.edu/faculty/yongheng-deng

Joseph Nichols

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-2983 (Phone)

Anthony Bown Sanders

George Mason University - School of Business ( email )

Fairfax, VA 22030
United States

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